Thursday, January 13, 2011

A New Model for Corporate Boards. By ROBERT C. POZEN
Companies have too many directors, and not enough of them have experience in the firm's main line of business.
The Wall Street Journal, Thursday, December 30, 2010
http://online.wsj.com/article/SB10001424052748703581204576033430665661032.html

In 2002, Congress passed the Sarbanes-Oxley Act to prevent corporate governance debacles like Enron and WorldCom from happening again. But six years later, many of the largest U.S. institutions had to be rescued by massive federal assistance. All of these institutions were Sarbox-compliant: Most members of their boards were independent, and their auditors' reports showed no material weaknesses in internal controls. So why were the reforms so ineffective?

I believe that the problem is the current structure of corporate boards. In short, they are too big, members often don't have enough relevant experience, and they put too much emphasis on procedure. Complex global companies need a new model. Boards should be comprised of a small group of people with enough pertinent experience and sufficient time to hold management accountable.

The average board size for companies in the S&P 500 was almost 11 in 2009. In groups this large, individual members engage in what psychologists call "social loafing." Instead of taking personal responsibility for the group's actions, they rely on others to take the lead.

Psychologists such as Harvard's Richard Hackman suggest that groups of six or seven are the most effective at decision-making. Groups of this size are small enough for all members to take personal responsibility for the group's actions. They also can take decisive action more quickly than a large board.

Although the Citigroup board in 2007 was filled with many luminaries, only one of the independent directors had ever worked for a financial-services firm. Of course, every board needs a generalist to provide a broad perspective and an accounting expert to head the audit committee. But the rest should have experience in the company's main line of business.

Most boards meet in person every other month for one day, plus conference calls between meetings. That simply isn't enough time to keep abreast of the global operations of a large company. An effective outside director should spend at least two days per month on company business between board meetings. Accordingly, independent directors should be restricted to serving on just two boards of public companies.

In all three respects, this model represents a significant departure from current board practice. Here are some pre-emptive answers to questions that will likely arise from my proposal:

When it comes to finding people with relevant experience, those most qualified to be professional directors often are working for the company's competitors. They obviously couldn't serve on a competitor's board due to conflicts of interest and antitrust concerns. As a result, most independent directors will have to be retired company executives (but not of the company in question). Many executives retire around age 60 in good health and want to continue to work, preferably on a part-time basis. They should serve as directors as long as they are capable, without a requirement for mandatory retirement at 70.

The average compensation of directors in S&P 500 companies is currently $213,000 per year. In this new model, professional directors would be putting in roughly twice the hours, so their total compensation should be approximately $400,000 per year.

To align the interests of professional directors with those of long-term shareholders, these directors should receive 75% of their total compensation in shares, subject to two conditions. First, these shares would vest in equal parts over four years. Second, at least half of the shares would have to be held until retirement.

Since professional independent directors will be more active in supervising the business of the company, will they become subject to increased legal liabilities? For example, if the head of a particular company's audit committee learns a lot about that company's finances, will he or she be personally liable if its financial statements contain material misrepresentations? No. Under federal securities laws, unless the audit head knew of these misrepresentations or recklessly disregarded them, he or she would not be liable.

Under state laws, state courts will override the business judgment of independent directors only if they do not act "in good faith." Because professional directors will be more diligent than today's norm, they will be in a particularly strong position to show that they acted "in good faith."

The most serious objection to my proposed model will probably be the concern that it could blur the distinction between the roles of the board and management. A board of directors has specific duties such as selecting the CEO, plus more general duties such as setting strategic goals. But the board is not supposed to get involved in day-to-day company management.

Although the new model will give greater power to professional directors, it would not empower them to cross the line into the day-to-day operations. Between board meetings, for example, professional directors would talk with managers to better understand the key decisions underlying the company's financial statements and the actual impact of its compensation policies. These sessions wouldn't amount to micromanagement. Instead, they would ensure that critical issues were fully addressed by the relevant board committees.

This new model could get adopted in several ways. First, bank regulators could use their "safety and soundness" authority to force troubled banks to elect professional directors. Second, activist shareholders might join together to pressure a poorly performing company into adopting this model. Finally, a few boards of large companies might be willing to try it out and see how it works.

Regulators, investors and directors should recognize that we do not need more procedures for corporate boards. Instead, we need more expert directors who view their board services as their primary profession—not an avocation.
Mr. Pozen is chairman emeritus of MFS Investment Management and a senior lecturer at Harvard Business School. This op-ed was adapted from an article appearing in the December 2010 issue of the Harvard Business Review.

President Obama's drilling commission released its 398-page report on the causes of the Gulf oil spill this week, and talk about a lost opportunity. After six months of hearings and interviews, the commission still doesn't know what caused the accident but does think it knows enough to condemn all and sundry.

The disaster, we are told, was primarily the result of "overarching failure of management" by BP, Transocean and Halliburton—which is hardly news to anyone who's been paying attention. Yet the commission didn't stop with the companies that managed the Macondo well, going on to blame the highly unusual blowout on a "system-wide problem" of failed regulation and a complacent industry that requires "significant reform."

These sweeping conclusions are remarkable from a commission that admits to knowing so little. The report cites several questionable decisions made by Macondo drillers as the "immediate causes" of the blowout, only to acknowledge it can't say which, if any, were the cause:

• "It is not clear whether the decision to use a long string well design contributed directly to the blowout."

• "The evidence to date does not unequivocally establish whether the failure to use 15 additional centralizers was a direct cause of the blowout."

•"Whether . . . 'unconverted' float valves contributed to the eventual blowout, has not yet been, and may never be, established with certainty."

Unable to name what definitely caused the well failure, the commission resorts to a hodgepodge of speculations. Adding to the confusion, it acknowledges it could find no evidence that BP or its contractors "consciously chose a riskier alternative because it would cost the company less money." The commission didn't even wait to get an autopsy of the failed blowout preventer, which is rusting on a Louisiana dock.

The report's one firm conclusion boils down to this: In the hours preceding the explosion, crew members missed "critical signs" that something was wrong. "The crew could have prevented the blowout—or at least significantly reduced its impact—if they had reacted in a timely and appropriate manner." This is called human error, in this case with tragic consequences to those who erred.

Yet it's hardly evidence that the entire drilling industry is an accident waiting to happen, as the commission insists. Its section "The Root Causes: Failures in Industry and Government" uses questionable decisions made by the Macondo players to suggest, with no evidence, that such behavior is the industry norm.

The report fails to reconcile this indictment with the industry's prior safety record, or with the fact that many countries have modeled their drilling technology and practices on those of the Gulf. For a better account of how unusual the Macondo practices were, we recommend the June 11, 2010 letter to the editor in this newspaper from Terry Barr, the president of Samson Oil and Gas.

The commission nonetheless offers an array of recommendations, most of which would severely restrict oil and gas drilling. Despite President Obama's promises that the new Bureau of Ocean Management (formerly the Minerals and Management Service) is now a shipshape regulator, the commission recommends that Congress create another agency to supervise drilling. Now, there's a new idea—another layer of bureaucracy to supervise the bureaucracy that failed.

The report also advocates toughening the National Environmental Policy Act to make it harder for companies to obtain drilling leases. Another section doubts it is possible ever to drill safely in Alaska or the Arctic—a hardy perennial of the anti-oil lobby.

This was all too predictable given the political history of commission members. Former Democratic Senator Bob Graham fought drilling off Florida, William Reilly is the former head of the antidrilling World Wildlife Fund, and Frances Beinecke ran the Natural Resources Defense Council, which is opposed to carbon fuels. Not a single member was a drilling engineer or expert in oil exploration technology or practices.

Compare this to the Rogers Commission, which investigated the Challenger space shuttle disaster of 1986. Led by former Secretary of State William P. Rogers, that group included theoretical and solar physicists, engineers and aeronautics specialists. The commission located the exact cause of the disaster (failed O-rings) and prescribed precise safety changes. The preface of the Rogers report states that the only way to deal with such a failure is to investigate, correct and "continue the program with renewed confidence and determination."

***

The unbalanced, tendentious nature of the commission report vindicates those who suspected from the start that this was all a political exercise. The White House has been pounded on the left for agreeing to ease drilling restrictions before the spill, and now it is looking for support to walk that back. Though the Administration officially lifted its Gulf drilling moratorium and issued new safety rules two months ago, it has refused to permit a single new well.

U.S. gasoline prices are now above $3 a gallon, and the decline in Gulf drilling will not help supply. Forecasters predict domestic production will fall at least 13% this year due in part to the Gulf lockdown. Meanwhile, last week the British Parliament rejected a drilling moratorium in U.K. waters on grounds it would cause "expertise to migrate," decrease "security of supply" and harm the British economy.

The BP spill was a tragedy that should be diagnosed with a goal of preventing a repeat, not in order to all but shut down an industry that is vital to U.S. energy supplies and the livelihood of millions on the Gulf Coast.